European equities have priced in a significant growth scare in recent months, such that there is now an attractive asymmetry in the risk profile of cyclical value compared to defensive growth.
In the second year of a recovery, investors often become nervous about the durability of the economic cycle. The second derivative in economic growth peaks, some reduction in extraordinary stimulus takes place, and risk aversion in markets can rise. European equities have seen a growth scare in the last few months, similar to 2004. Whilst the movement in absolute terms has been contained, there have been sharp moves in relative terms. Incredibly, in some measures, value is now cheaper than ever before.
In relative price to cashflow terms, the picture is stark. Below we show the price to cashflow of “cyclical value” as shown by EU Energy & Autos compared to “defensive growth” which includes EU Tech & Staples. Since the pandemic low, the operational performance of many value sectors has been strong, with significant cashflow growth. Even though share prices have risen, cashflow in many cases has risen more, keeping valuations low. In this case, the price to cashflow of Energy and Autos is now just 18% of Tech & Staples. This is more than 2 standard deviations away from the 11 year average of 37%.
In price to book and price to sales terms, valuations are also close to an extreme. Below we include EU Banks & Materials in our “cyclical value” bucket, showing the relative price to book and price to sales of EU Banks & Materials compared to EU Tech & Staples.
The standard risk to owning cyclical equities is that the cycle may be over and so a drawdown in earnings could occur. The comforting element today is, even if the cycle is over, valuations reflect this risk in relative terms. It is hard to make a case for relative downside, irrespective of the trajectory of the economy. Absolute downside risk is also strongly contained, given very low absolute valuations.
Fortunately, as we have written earlier this summer, the probability of the cycle being over is low. Accumulated savings are at record highs, governments are keen to spend and monetary policy is extraordinarily supportive. German real yields are now at an all-time low of -2.15%.
The current liquidity, fiscal and monetary backdrop is supportive of equities, and especially so for cyclical equities. Yet investors have crowded back into defensive growth stocks. The premium for these growth companies now looks dangerously high, similar to September 2020. The smallest of good news ought to cause a push higher for value in absolute and relative terms. Good news could also pose a risk to the absolute price of some defensive growth stocks. If the economy is not about to enter a recession, the valuation premium of these “secure growth” stocks may be hard to justify.
The LF Lightman European Fund is at an attractive valuation. The fund has a 2022 PE ratio of 9.4, a dividend yield of 4.5%, a price to sales ratio of 0.92 and a price to book ratio of 0.98. The balance sheet of our portfolio holdings is also strong. Well over 50% of our holdings are net cash or close to it – with less than 1x net debt to ebitda.
A significant majority of the portfolio is exposed to the clean energy transition, a secular driver of earnings for at least the rest of this decade. This clean energy earnings driver, which is now written into law, can help to reduce the cyclicality of earnings and drive up the rating of many of our holdings.
The growth scare of the last few months looks like an opportunity to add to value, or for those with no exposure, a second chance to enter – similar to September 2020.
Sources: Lightman – August 2021
Risk: Past performance is not an indicator of future performance. The value of investment might fall as well as rise.
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